Contracts that Reward Innovation: Delegated Experimentation with an Informed Principal

Abstract

We examine the nature of contracts that optimally reward innovations in a risky environment, when the innovator is privately informed about the quality of her innovation and must engage an agent to develop it. We model the innovator as a principal who has private but imperfect information about the quality of her project: the project might be worth exploring or not, but even a project of high quality may fail. We characterize the best equilibrium for the high type principal, which is either a separating equilibrium or a pooling one. Due to the interaction between the signaling incentives of the principal and dynamic moral hazard of the agent, the best equilibrium induces inefficiently early termination of the high quality project. The high type principal is forced to share the surplus -- with the agent in the separating equilibrium, or the low type principal in the pooling equilibrium. A mediator, who offers a menu of contracts and keeps the agent uncertain about which contract will be implemented, can increase the payoff of the high type principal to approximate her full information surplus.